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Why current regulatory actions are STILL missing the boat on CRE

There are a lot of "CRE is crashing" articles in the news these days. I wonder, where were they two years ago when the signs were first quite evident? See excerpts of my many and verbose warnings starting in 2007 at the end of this article. As I gave it some thought, and pondered on the global equity markets rip roaring tear through the low volume bullishphere, I came to the conclusion that many, if not most, truly do not understand the fundamental difference between price and value. Everybody with access to a spreadsheet, calculator, abacus or ten fingers for the old fashioned method of counting should have known the CRE market was overheated, just as they should know now that the equity markets are overheated.

The dilemma is that market participants, big and small, advanced and beginner, appear to perpetually fail to shake the premise that market pricing is not necessarily corollary with the truth from a fundamental perspective. I have had this argument many a time with the opponents of mark to market rules. Their argument then is the same as mine is now, except for none major difference. If the market is the sole credible method of determining the value of one's assets, then the market price is the bid, which is the value - period! CDO cubed holders seem to have a big problem understanding that. Commercial real estate is a very different animal, wherein cash flows are much more measurable, stable and predictable. As a matter of fact, cash flow and NOI analysis is the standardized methodology in valuing CRE. So, with that being the case, what happened to catch so many people out there in terms of valuation, and why has such a big crash come with so few people seeing it before hand?

The answer to that question brings us back to the original premise, "those that follow only market prices, will never be able to understand the difference between price and value". Cap rates, NOI's, credit availability and cash flows that were used to justify stratospheric CRE prices in business plans and projections never materialized, and any objective glance at such would have shown the objective speculator that they would probably never materialize. The reason? They were based upon market pricing vs being based upon fundamentals. Market prices were going up, while fundamentals were pointing down. This created, in essence, a giant Ponzi scheme that enriched those who got in and out early enough, but devastated those who thought the game was real and stayed too long - basically, it broke those who thought price and fundamentals were corollary.

This brings me back to the derivative mark to market argument. There were those that said market pricing was off due to the fact that the assets were throwing off cash. Yes, they were, but the fundamental trend of those cash flows was pointed downward. The same argument was able to be made with CRE in 2006 and 2007, just by looking at trends in a spreadsheet. Don't believe me, look at this 2007 graphic that I made:

You see, following price can make you look like a superstar when prices are roaring upwards in a raging bull market (or bear market rally), just as it can make those who call it for what it is look unknowing or off the mark, if not just plain wrong. At the end of the day, though, fundamentals wiill always reign supreme because numbers (fundamentals) are how you quantify money, and investments are all about money.

What happened in CRE during 2005 and 2006 is happening in the stock markets in 2009. I can always say I told you so, but unfortunately we have to wait and the vindication must come after the fact - which tends to damage those who were disbelievers. So, now I move on to today's CRE environment, which is (as I clearly anticipated and demonstrated 2 years ago) clearly crumbling. Regulators and bankers are attempting to address this malady by injecting heavy doses of virulent flu virus into patients who are bed ridden from the flu. What you say? Well, as we all have surmised by now, an overactive and unregulated (effectively) securitization and lending market is what empowered banks, developers and investors to look the other way when it came to pie in the sky operating income and cash flow numbers. It also emboldened many to purchase buildings at cap rates that were damn near the treasury yield, which (of course) made no sense to the fundamental investor since commercial real estate is one of the most risky investments one can make and to do so for the same compensation as one could get in the so called "riskless" investments was a warning sign in and of itself, at least to the fundamentalist. Yet, you see, when describing those who chase prices in lieu of value (like today's stock market or yesterday's CRE deal) we are not dealing with fundamentals types, we are dealing with those who say, "look, the price went up, which means I was right and you were wrong".

The central bankers and the regulators seem to be trying to extend that mentality by kick starting the very program that wrought these excesses to begin with. Let's walk through this recent Bloomberg article on the Fed and CRE for an example...

The collapse in commercial real estate is preventing Federal Reserve Chairman Ben S. Bernanke from declaring the economy and financial markets are healed.

Property values have fallen 35 percent since October 2007, according to Moody’s Investors Service. That’s making it tough for owners to refinance almost $165 billion of mortgages for skyscrapers, shopping malls and hotels this year, pressuring companies such as Maguire Properties Inc., the largest office landlord in downtown Los Angeles, to put buildings up for sale. As would be expected in a market-based economy. The ability to refinance negative equity assets will simply blow another bubble because the only way to refinance them is to create faux equity by synthetically lifting the price or dropping the cost of financing below the market rate. It appears as if bankers and regulators are looking to try both, when the only true solution is to allow the market prices to find equilibrium, and that point is still downward. CRE pricing is a function of cash flow and NOI, and these come from strong renters and low expenses. We have neither in this struggling economy.

The industry is likely to be high on the agenda when Bernanke and his colleagues sit down in Washington tomorrow for the Federal Open Market Committee meeting on monetary policy. Lawmakers including Barney Frank and Carolyn Maloney are pushing the central bank to extend an aid program designed to restore the flow of credit. Herein lies the problem. The flow of credit will be restored by the market, just as it has been for the past several thousand years, once the market sees pricing and valuation come bank in line with the prospects of extending credit. It appears as if our dear government is trying to force credit onto a still overvalued market. They are, in essence, purposely, forcibly, and unwisely trying to blow a bubble to deal with a popped bubble. These mistakes are, ironically, how I make my money. See "The Great Global Macro Experiment, Revisited". There will always be opportunity for profit for those who adhere to fundamentals when central bankers try to fix problems with more problems.

If nonresidential real estate remains in the doldrums, the Fed may be forced to leave emergency-lending programs in place and keep its benchmark interest rate close to zero for longer than some investors expect, given positive signs elsewhere in the economy. Non-residential real estate will come out of the doldrums once pricing comes in line with realistic cash flow expectations. Until then, nothing is going to help it in any sustained form or fashion, and additional flu virus injected in the flu victim will just make it sicker.

Commercial property is “certainly going to be a significant drag” on growth, saierd Dean Maki, a former Fed researcher who is now chief U.S. economist in New York at Barclays Capital Inc. the investment-banking division of London-based Barclays Plc. “The bigger risk from it would be if it causes unexpected losses to financial firms that lead to another financial crisis.”Oh, but you see the losses are already there in an economic sense, The reason why it has not manifested itself in the accounting earnings that lay people and retail investors follow is the conspiracy between the government, the industry and the bankers to conceal losses via a most unwise laxing of the accounting rules and interpretation.

...

‘Danger Zone’

Amid such glimmers of improvement, commercial real estate is a “particular danger zone,” said Janet Yellen, president of the Federal Reserve Bank of San Francisco, in a July 28 speech in Coeur d’Alene, Idaho. The market may be “under stress for some considerable period of time,” William Dudley, chief of the New York Fed bank, said the following day in New York.

Nonresidential construction may decline as much as 9 percent this year and another 5 percent in 2010, predicts Kenneth Simonson, chief economist at Associated General Contractors of America, an Arlington, Virginia, trade group whose members include Essen, Germany-based Hochtief AG’s Turner Construction Co. in New York, one of the largest U.S. builders. In the second quarter, it accounted for 3.6 percent, or $509 billion, of U.S. gross domestic product on an annual basis, down from 4.3 percent in the final three months of 2008. I'm perpetually awed at how academics seem to universally to universally believe that construction is a positive sign. In a glutted environment, more supply means more pain. In a technically perfect academic world, no one would build unless they felt the demand was there. In the real world, they build due to contractual obligations to lenders and investors, stupidity, the belief (right or wrong) that an extant, empty building will be worth more than an empty lot, etc. Unfortunately, many economic academics fail to take these real life factors into consideration.

A dozen lawmakers questioned Bernanke on the topic during his July testimony. Some asked about extending the Term Asset- Backed Securities Loan Facility, the emergency program the Fed began in March to restart the market for securities backed by auto, credit-card and education loans. The central bank expanded the facility in June to cover as much as $100 billion in loans to support commercial mortgage-backed securities.

One-Year Extension

Forty-one House members -- including Frank, 69, a Massachusetts Democrat who chairs the Financial Services Committee, and Maloney, 61, a New York Democrat who heads the Joint Economic Committee -- signed a July 31 letter seeking a one-year extension through December 2010 and asking for a decision by mid-August.

Fed policy makers will prolong the program if they judge financial markets are still “some distance from normal operation,” Bernanke said during his July 22 testimony. “We will certainly be monitoring the situation.”Actually, the markets are probably closer to normal operation than they are to abnormal operations. Who in the world expects lenders to loan against underwater properties??? It is not the credit markets that are the problem, it is the solvency issues of the owners that are the problems. I bet a strong cash flowing, 90% equity property would have no financing issues.

The Fed likely will change the end date -- just not right away, said former central-bank Governor Lyle Gramley.

...

Any sales of mortgage-backed bonds would be the first new issues in the $700 billion U.S. market for commercial-mortgage- backed securities since it was shut down by the credit freeze in 2008.

About $3 billion are in the pipeline, and the success of these sales may foster as much as $25 billion in total deals in the next six months, said Kenneth Rosen, who runs a $310 million hedge fund in real-estate securities and heads the University of California’s Fisher Center for Real Estate and Urban Economics in Berkeley. It really doesn't matter how much money is put into the lending program. Sooner or later, people are going to want real profits. Property values will have to go down (read as equity infusions will have to go up), or rental incomes will have to go up before the financing deals become more prevalent. Once economic value is brought back into the equation, you will not need government intervention programs to get lenders to lend. The money will develop out of plain, old fashioned greed and competition. Now, greed and competition won't come into play because the prospect of throwing money into insolvent or potentially insolvent situations is just not appetizing.

Signs of Improvement

The market is showing some signs of life: The Bloomberg REIT Office Property Index of 14 companies, while down 56 percent from its February 2007 peak, has gained 41 percent in the past six months. Also, the yield gap, or spread, on top- ranked commercial mortgage-backed bonds relative to U.S. Treasuries is about 4.49 percentage points compared with 8 percentage points at the start of May, according to Barclays data. How are we going to know if these are actually signs of improvement? Because prices are going up a little? Prices went up in 2006 and 2007, which is why we are in this mess to begin with. The true signs of improvement will come from improvement in fundamentals. The most prominent sign would be a firming of rentals stemming from stronger renters. This will enable higher rents, which would then justify more debt, and potentially and probably higher prices. If a materially and significantly tampered market shows price increases without these underlying fundamental improvements, then all you have is another bubble in the making.

The Fed’s efforts to revive credit may be overpowered by continuing job losses, even as the pace of those losses slows. U.S. employers eliminated 247,000 workers from payrolls last month, according to an Aug. 7 Labor Department report, bringing the cumulative reduction to about 6.7 million since the start in December 2007 of the worst contraction since the Great Depression.

‘Negative Fundamental’

“Demand for commercial space comes from employment and the income generated by that employment,” said University of Pennsylvania Professor Joseph Gyourko, director of the Wharton School’s Samuel Zell and Robert Lurie Real Estate Center in Philadelphia. Mounting job losses are a “really significant negative fundamental,” signaling that “conditions are going to be tough for the industry for a while,” he said. Finally, some common sense.

That may spill over into mounting losses at some banks. "May"??? Actually, its guaranteed. See PNC below. Forty-seven percent of loans at the 7,000-plus smaller U.S. lenders are in commercial real estate, compared with 17 percent for the biggest banks, according to New York-based Goldman Sachs Group Inc.

Regions Financial Corp., the Birmingham, Alabama, lender that accepted $3.5 billion in U.S. rescue funds, had $36.9 billion in nonresidential real-estate and construction loans at the end of the second quarter, 38 percent of its overall total. Regions posted a net loss for the period of $188 million compared with a profit of $206.3 million a year earlier as more developers and home builders fell behind on payments.

Third Straight Loss

Salt Lake City-based Zions Bancorporation, which operates in 10 Western states, reported its third straight quarterly loss July 20 on a surge in commercial-property defaults. Thirty-five percent of its loans for the period were in nonresidential real estate and construction, and its provision for loan losses rose to $762.7 million from $297.6 million in the first quarter.

One developer based in U.S. Representative Walt Minnick’s district is in a bind because a lower appraisal means he can’t renew the full amount of a $10 million, three-year loan he took out for a recent project, the first-term Democrat from Idaho said in an interview last week. The person may be forced into bankruptcy, said Minnick, 66, without identifying the developer.

“That is a microcosm of what is happening to commercial property” everywhere, he said. “It’s the next shoe to drop.”

Relinquish Control

Maguire bought 24 properties and 11 development sites for $2.88 billion in 2007 from New York-based Blackstone Group LP, the world’s largest private-equity company. Later that year, credit markets froze, blocking the Los Angeles-based company’s efforts to refinance its mortgages. Now Maguire may relinquish control of seven Southern California buildings with $1.06 billion of debt, the company said today, adding it’s not planning on filing for bankruptcy.

New York-based Brookfield Properties Corp. faces a $1.8 billion debt maturity in October 2011 arising from the 2006 purchase of Trizec Properties Inc., which made it the second- biggest owner of U.S. office buildings by square footage. Brookfield has said it expects to refinance some of its obligations and sell buildings to cover the rest.

Commercial real estate remains “an important downside risk,” said Gramley, a Fed governor from 1980 to 1985. “I don’t think it’s going to be a blockbuster negative, but it’s one additional reason why this recovery is going to be of modest dimensions.”

I have visited commercial lending risk many times before, starting with my work on GGP, which is now bankrupt, but not before I gave my readers a warning 2 years ago. See my posts from 2007 and early 2008:

Commercial real estate values in the U.S. remained on an upward trend long after the 2nd half of 2006, when the housing prices began falling in most MSAs. Commercial real estate values peaked and began falling towards the end of 2007 and continued to decline through 2008.